Understanding Interest Rates & Capital Markets: Types, Determinants, & Money Markets - Pro, Study notes of Banking and Finance

Download Understanding Interest Rates & Capital Markets: Types, Determinants, & Money Markets - Pro and more Study notes Banking and Finance in PDF only on Docsity! Lecture #1 BUSINESS CYCLES There is more or less a pattern of expansion (recovery) and contraction (recession) in economic activity around the path of trend growth. At cyclical peak- economic activity is high relative to trend. At cyclical trough ?? Over time what causes the trend line to change ? More resources Factors not fully employed all the time. What is inflation ? Why worry about inflation instead of unempmt.? 1 Lecture #2 MARKETS What are they ?? What makes a good market ?? Can we name some “bad” markets ?? FINANCIAL MARKETS & INSTITUTIONS I. Financial markets exist to aid in the most efficient allocation of capital II. Financial Institutions facilitate this allocation of capital. 2 Intermediaries also incur risks……… I/R risk FX risk Credit or default risk What about Foreign Mkts & Intermediaries ? Provide for borrowing or investing abroad Important source of diversification Lecture #4 5 What is an interest rate ? Compensation for lending or giving up one’s abilitiy to spend today. Can be a measuring guideline governing corportate investing. Why do we care about interest rates ? They influence the allocation of capital. They impact the economy and decision making. How do we look at interest rates and time ? Concept of Present Value Present value allows you to place a value on future funds. What might $10 today be worth 10 years from now ? 6 The Present Value calculation converts cash flows received in the future to a value assuming receipt today (the PRESENT ). How much is $3000 received in two years worth today if the interest rate is 4% ? How much is $2000 next year and $3000 the year after worth today if the interest rate is 5%? 7 What might cause the curves to shift ? SUPPLY: I/R Wealth Risk Near term spending needs Monetary Expansion Economic Conditions DEMAND: Current utility Economic conditions Restrictiveness of nonprice conditions. Lecture #6 What are the factors that can affect the i/r for an individual security ? 10 Begin with the “real interest rate “ Direct correlation between inflation & i/r.. U.S. Treasuries become the benchmark.. What factors influence nominal i/r ? Default risk Liquidity risk Covenants- puts/calls Term to Maturity Ubiased Expectations Theory 11 Liquidity Premium Theory Market Segmentation Theory Lecture #7 What does the yield curve tell us ? 12 Objectives: Moderate long-term i/r Maintain high level of employment Stable prices Economic growth It’s duties: Conduct monetary policy Supervise/regulate depository institutions Maintain stability of financial system Provide payments services for governments Also check clearing & wire transfers Independent of Executive Branch Oversight by Congress Chairman/Vice Chair appointed by President 15 12 Regional Banks 7 Member Board of Governors 5 of Regional Bank Presidents + Board of Governors comprise the Federal Open Market Committee (FOMC) The objectives shown above are their job…. What is important is how they do it…. Lecture #9 MONETARY POLICY What is it and how does it affect us ? 16 In essence it is an attempt to influence the amount of reserves that remain in the banking system….which in turn affects i/r and the availability of credit…which ultimately affects the levels of employment, output, and prices and inflation. In other words the money supply. MONETARY POLICY TOOLS Open Market Operations Discount Rate Reserve Requirements The FOMC impacts the economy thru its practice of buying and selling government securities in the open market. In so doing they are either adding money (expanding) to the existing supply or taking it out (contracting). Discount rate – Rate Fed. Charges bank to borrow from it….In reality is only used as a signal to the market as to which way the Fed wants to see rates go. The discount rate was 17 Active secondary market/ very liquid Capital markets > 1 year Characteristics of money market instruments: Large – usually $1 mil. + Low default risk Maturity of 1 year or less Corporates and governments usually sell money market instruments to meet short term needs. TREASURY BILLS Default risk free 20 Benchmark for other securities pricing Refinancing debt/govt. deficit/tax timing Sold at auction weekly Shortest maturity is 13 weeks. Sold at a discount Suppose you buy a 26 week T-bill for $9500 whose face value is $10,000. What is the discount yield ? i = 10000-9500/10000 x 360/182 = 9.89% FEDERAL FUNDS Primarily overnight loans between banks. One of the uses of their excess reserves. 21 FED sets the lending rate. For all practical purposes are just lending cash between two banks. REPURCHASE AGREEMENTS (REPOS) Actual sale of securities between two parties with agreement to repurchase at set date and price. Is collaterized most often with govt. securities. Normally 1-14 days but can go 90. More secure than Fed Funds so has lower yield…often as much as 25 basis points. Lecture #11 COMMERCIAL PAPER (CP) An unsecured promissory note issued by corporations. 22 Issuer Investor T-bills Treasury Fed/Banks/Cor Fed Funds Banks Banks Repos Fed/Banks Fed/Banks/Cor Cp Banks/Corps Corps/FI’s Neg. CD Banks FI’s/Corps BA’s Banks Banks/Corps Where are there secondary markets ? Where are yields the highest/lowest ? Who are the important FI’s ? Summary – Money markets are important to: 25 The Fed – for controlling the money supply. Banks – to meet reserve requirement and as a place to use excess reserves. Broker-Dealers – Keep the market moving Corporations - source of short term funding and as a place to invest short term cash. Other FI’s – A place to maintain liquidity. INTERNATIONAL MONEY MARKETS 26 Foreigners are major investors in Treasuries Diversification and default free Keep deposits in foreign countries to facilitate exhange into $. LIBOR is major lending rate. Now major rate measurement for all types of loans, not just foreign. Borrowing is usually quoted as a spread over LIBOR…might be 350, 30 or 3…depending on the risk associated with the borrower. Lecture #12 THE BOND MARKET 27 Secondary market very thin. CORPORATE BONDS Comprise about 57% of o/s bonds. Normally issued to fund long term obligations. Rating agency comments are critical to price. Debentures – no collateral Subordinated debentures – junior in status Convertible bonds – debt that converts to equity at some point in time if certain things occur. Callable bonds Sinking funds Moody’s/S & P / Fitch Who are buyers of the various types of bonds? Which bonds likely carry the highest and lowest yields ? 30 INTERNATIONAL BOND MARKETS Eurobonds – Sold outside the country of the currency in which they are issued. Could be dollar denominated bonds sold in Japan. Foreign bonds – Bonds issued outside the home country but denominated in the host country currency…Samurai bonds are dollar denominated bonds issued by Japanese borrowers in the U.S. Brady bonds – bonds substituted in a restructuring of a less developed country’s debt. Longer term and lower rates. Backed by the U.S. Treasury Sovereign bonds – specific country issued . Lecture #13 MORTGAGES Loans to purchase real property such as a home, land or building. 31 75% of mortgages are for single family dwellings. Characteristics of a mortgage: Size, term, i/r, collateral Qualifications – fairly standard, income to value ratio (can you make the payments) Down payment – reduces default risk Conventional vs. Insured. Maturity – 15/30 yr….. balloon payment I/R – Fixed vs. ARM Greenspan ARM quotes. Amortization schedule Refinancing depending upon rate cycle. Originate with FI’s most of whom do not continue to carry them on their balance sheet. 32 Indices: DOW / S & P 500 / Wilshire 5000 What causes prices to change on the Market ? Efficient market theory / Random walk Lecture #15 FOREIGN EXCHANGE Global trade requires that we exchange currencies. 35 The foreign exchange rate is the ratio of one currency to another. How yen equal one dollar ? Initially had fixed currency rates. And Gold !! Eventually floating. Now the Euro !! Can use spot or forward markets to make exchange rate more predictable. What causes exchange rate differentials between countries ? Economic flows between countries are measured by the balance of payments. Current Account: Merchandise trade balance Service sector Unilateral transfers 36 Capital Account : Direct investment Portfolio investment Lecture #16 DERIVATIVES Financial instruments tailored to change where risk lies. 37 You can purchase indices made up of the major stocks….Dow/ S & P 500, etc. You can use these to hedge (as a derivative) other stocks you own. SWAPS – the most used derivative…great fun !! Two parties agree to swap cash flows some time in the future based upon some underlying asset. Terrific tool for companies to manage i/r risk, currency risk and credit risk. Sold bond last year - $100 mil. 10yr – 7% coupon. Now I think rates are going to trend down. What can I do about it now ? Nothing changes with the underlying assets…only the cash flows tied to them. Currency swaps – evening out exposure Swap markets – Counterparty risk 40 Caps (ceilings) – limit the upside exposure. Floors – protect the bottom Collars – give up a little to establish a range of risk. .Lecture #17 COMMERCIAL BANKS Serve as principal channel for government monetary policy. 41 Loans are assets/Deposits are liabilities. How then do banks make a profit when their chief assets and liabilities are just pieces of paper ?? ASSETS: Loans – A promise to repay – Approx. 60% of assets. Loans to whom ? Business – 25% of total Revolving lines of credit Seasonal (inventory) Floor plans Fixed – collateralized Real Estate – 46% of total Commercial and residential Mortgages/equity lines of credit Consumer credit – 16% International Investments 42 Serves as a cushion against a drop in assets. What happens when liabilities exceed assets ? Japan banking crisis What happens in a recession to bank business ? Banks frequently have lots of business off their balance sheets. Swaps, derivative contracts, some loan commitments, foreign exchange contracts, etc. Why would they do this ? Commercial bank companies have been growing because of the change in the law allowing branching. This has brought on major merger/acquisition activity. More income coming from non-interest/fee based business. 45 Commercial banking – International U.S. banks going abroad: Less regulation New business Follow their customers Risks are higher – As are returns Credit Political Currency Banking around the World Japan-China-Euro The Regulators Lecture #18 THRIFTS Historically small institutions serving specialized needs of local groups. 46 Savings assoc. (formerly S & L’s)…population has declined by 75% over last 20 years. Now about 1200. Traditionally made long term fixed rate mortgages to individuals funded by short term deposits. Problems of the 1970’s / Regulation Q Disintermediation Garn-St. Germain Act of 1982 / NOW-MMDA Oil collapse / Regulators failed / New regulators Assets: Mortgages and mortg. Backed sec. 73% Comm. Loans – 3% What happens in an economic downturn ? Thrift liabilities: Over 60% is small deposits. Fed. Home Loan Bank borrowings = 22% Equity (capital) = 8.2 % What happens in an economic downturn ? 47 Life insurance – allows individual to protect themselves and their benefactors against the loss of income from death. Insures pool risks – why / What happens if they are wrong ? Types of life insurance: Ordinary life Term life Whole life Endowment life Variable life Universal life Group life Credit life Annuities GIC’s Accident and Health What do the balance sheets of Insurers look like ? 50 Premiums are assets – long lived Investments ? Policies are liabilities Regulation is at state level. Business getting more competitive with brokerages, banks entering. Property & Casualty: Fire Homeowners Commercial Auto Liability Premiums are assets / claims are liabilities How do these companies ever lose money ? Lecture#20 SECURITIES FIRMS & INVESTMENT BANKING Securities firms….. 51 Investment banks….. Activities: Investing Investment banking Market making Trading Cash management M & A Others: Research……the scandals…tying arrgmts. SEC / Spitzer Lecture #21 FINANCE COMPANIES Lenders to consumers, businesses, mortgages. How are they different from Banks ? 52 Private plans: 401-k IRA Keogh Public plans State & local Federal Lecture #24 REGULATION OF DEPOSITORY INSTITUTIONS Crucial – Confidence in FI’s key for domestic and International business. Safety & Soundness Monetary Policy 55 Credit Allocation Consumer Protection Investor Protection Entry & Chartering Reg. of Product & Geographic Expansion Prior to crash Glass – Stegall Section 20 Glass – Stegall repeal Geog. Expansion- Unit/restricted branching/interstate branching FDIC FSLIC Why did problems of the 1980’s arise ? Balance Sheet Regulations: Focus on leverage Capital to assets ratios become triggers: >5% all the way to <2% On balance sheet versus including off balance sheet 56 What is history of foreign banks ? Social Security problems / solutions Lecture #25 FINANCIAL INSTITUTION RISKS Credit – Bad investments/ Bad loans Firm specific risk Systemic risk Liquidity – High withdrawals/ “run” 57 Small business lending looks at cash flow of the business. Mid-market focuses more on the business itself….cash flow/customer book/cyclicality In the end, how predictable is the cash flow / Credit analysis of the smaller firms is critical. The 5 C’s…. Character/Capacity/Collateral/Conditions/ Capital Haircuts Ratios Large borrowers: Tougher sell for the FI. More options. Information is better. Once you have decided to make the loan how do you decide what to charge for it ? In other words, how do you make money at this game ? RAROC 60 How much is a relationship worth ? Lecture# 27 MANAGING LIQUIDITY RISK I WANT MY MONEY NOW !!! Can purchase liquidity or use stored liquidity. Runs and panics 61 FDIC Fed Discount Window Life Insurance Co. liquidity risk Property and Casulty liquidity risk Mutual Funds liquidity risk Lecture #28 INTEREST RATE & INSOLVENCY RISK Measuring the Risk….. Rate Sensitive Assets and Liabilities 62